The Potential and Perils of Title III Crowdfunding

For the first time in 80 years, thanks to Regulation Crowdfunding, startups and small businesses can raise up to $1 million from friends, family, customers and non-accredited investors. As of May 16, 2016, the JOBS Act’s Title III Regulation Crowdfunding exemption enables capital-raising via Securities and Exchange Commission-registered websites.

Prior to this SEC provision, entrepreneurs’ financing options came down to personal savings, credit cards, banks (if they could qualify) and angels or VCs (if they were among the lucky few). While most media attention about this new opportunity has focused on an entrepreneur’s ability to sell shares (equity) in his or her high-growth-potential company, a real (and neglected) opportunity is for Main Street businesses to raise debt capital through crowdfunding.

The Perils

I have been a bit skeptical and critical when it comes to equity crowdfunding for non-accredited investors (investors with less than $200,000 in annual income or $1 million in wealth, not including home equity). A valuable part of equity investments comes from the people investing financial capital. Angels and VCs often take very active roles in their portfolio companies—as advisors, as board members, as champions—opening doors and making valuable connections.

When companies crowdfund, investors usually don’t have contact (or access) to the founding teams. The relationship is brokered through online portals that aggregate multiple small investors into one special-purpose investment vehicle. The investors usually don’t have voting rights or any real input in the company’s operations. So, companies get some funding, but they don’t get the valuable active participation from investors that usually comes with those equity investments. I often refer to this as “dumb money,” not because the investors are dumb, but rather because it’s not the “smart money”—financial capital that comes with the added value of human capital.

Accredited investors are assumed to be “sophisticated” investors. That’s actually a bad assumption because lots of dumb angel investing goes on in this country. Angel investing is risky, but there are ways to mitigate some of that risk—for example, by building a diversified investment portfolio; investing in sectors where you have expertise; investing with an angel group, which brings together people from different backgrounds, experience and viewpoints; and by doing rigorous due diligence on the company, the founders, the market and the competition. I assure you that many angel investors don’t do any of those things.